Covid-19 is primarily a health and human crisis but is increasingly evolving also into an economic crisis. It is not yet a financial crisis; rather, so far the financial sector has been central to directing financial resources to support economies and societies while they battle the pandemic.

However, as the economic contraction continues to lengthen and deepen, the epicentre of the Covid-19 crisis is increasingly evolving into one that raises critical questions about the structure of the economy and the longer term solvency of the financial sector. Banks around the world are increasing their provisions for losses, and levels of non-performing loans (NPLs) and other exposures are increasing.

Banking crises are commonly caused by stressed balance sheets as a result of over-extended loan books which gradually transform into high levels of NPLs. The longer the impact of Covid-19 continues, the more the level of NPLs will inevitably rise, threatening a systemic solvency crisis in the banking sector. In the event of a systemic banking solvency crisis, regulators will need to choose the most effective strategies for stabilization of the financial system and the economy.

A wide range of approaches has been applied to address banking and other financial crises. The nature of the approach depends on the type of the crisis, its origins, evolution and context. Systemic banking crises are among the most common and costly to address. The three major international financial crises of the past 25 years—the Asian Financial Crisis, the Global Financial Crisis, and the European Debt Crisis—offer critical lessons regarding the most effective approach to address bank solvency in a systemic crisis. One of the most common and also effective methods has been the transfer of NPLs to an Asset Management Company (AMC) that performs workouts or liquidates stressed loan portfolios at a more opportune time to amortize losses. In most cases the use of AMCs has delivered positive results for the taxpayer.

On the other hand, contemporary consensus as regards tackling bank solvency during a systemic financial crisis focuses heavily on prevention of government bailouts in order to protect state finances and curb moral hazard. This attitude is strongly influenced by a desire to prevent the emergence of too-big-to-fail financial institutions and the experience of the 2008 crisis wherein senior bank executives walked away with large bonuses while leaving the taxpayer to pick up the bill of failure. However, an overly dogmatic focus on preventing public financial support in the context of a systemic bank solvency crisis may place insurmountable obstacles to the use of state-backed AMCs and other forms of NPL resolution and bank recapitalization.

Our new paper—‘Resolution of Systemic Banking Crises and Financial Instability due to COVID-19: Toward an Appropriate Role for Public Support and Bailouts’—analyzes evidence from the three major international banking crises over the past twenty-five years to explain why restructuring banks’ balance sheets is the most effective approach to resolve a systemic banking crisis. The paper provides a new perspective on the common belief that public support in the context of systemic bank insolvency— ie bank bailouts—is an inefficient use of public funds or conducive to moral hazard.

Our study finds that state-backed AMCs can be effective in recapitalizing banking systems, depending on the modus operandi of the restructuring, funding and the conditions attached to the fiscal backstop. With respect to systemic banking crises or those caused by exogenous factors, such as the unprecedented disruption of economic activity due the Covid-19 pandemic, preservation of financial stability and not containment of moral hazard should be policy-makers’ predominant goal. Thus, we suggest that a combination of balance sheet restructuring and the use of AMCs to manage NPLs is the optimal approach.

Experience from previous major crises suggests that when tackling NPLs and bank restructurings, a shift towards balance sheet strengthening is of the utmost importance rather than obsessing over mitigating moral hazard. Focusing on balance sheet strengthening and adopting a pragmatic rather than dogmatic approach to bank crisis resolution will be of paramount importance for the support of a robust economic recovery in the post-Covid 19 era, for both developed and developing countries.

Douglas W Arner is the Kerry Holdings Professor in Law at the University of Hong Kong

Emilios Avgouleas is a Professor and holds the Chair of International Banking Law and Finance at the University of Edinburgh

Evan C Gibson is a Research Fellow at the Asian Institute of International Financial Law, at the University of Hong Kong